On the floor of a stock exchange, such as the New York Stock Exchange (NYSE) or the American Stock Exchange (AMEX), equities are traded by firms which are generally referred to as brokers. Some of these brokers are officially given the exclusive right to maintain the market for one or more particular stocks, and these firms are called specialists, because they specialize in trading those one or more particular stocks. And within that firm, a particular individual serves as the firm's specialist in handling one or more of those stocks for which the firm serves as the specialist. In general, most of the transactions for a particular stock are handled automatically and instantaneously. This is because a single specialist is responsible for handling all the conventional buy and sell orders. However, the privilege of having the exclusive right to trade in a certain stock comes with certain obligations and responsibilities. Chief among these is the obligation to help stabilize the share price of the stock in which that specialist specializes in a volatile market. Thus, if the share price drops precipitously during the course of a day, the specialist is expected to cushion the falling share price by purchasing a significant number of the shares so as to prevent a free fall in the price of that stock. A specialist is typically human, but the specialist role may also be fulfilled by a virtual specialist, as disclosed in U.S. Pat. No. 5,950,176 to Keiser, whose contents are incorporated to the extent necessary to understand the present invention.
Unlike the NYSE and the AMEX, the National Association of Securities Dealers Automated Quotations System (NASDAQ) does not have brokers and specialists, but rather has dealers, each of whom is free to handle trades in any stock. Thus, there is no official exclusivity in trading a particular stock and so each dealer is authorized to conduct transactions between buyers and sellers. Because a sale of a security on the NASDAQ can theoretically be handled by any number of dealers, transactions between buyers and sellers may not take place as rapidly as they do on the NYSE or AMEX. Furthermore, because there is no exclusivity, the dealers on the NASDAQ are in no way obligated to cushion the fall in the price of any given stock, a factor which contributes to wider percentage swings in the share prices of the stocks listed in the NASDAQ.
Mutual funds are an alternative to individual investing and typically pool money from several investors into a single pool. The pool is then invested in at least two, and oftentimes far more, stocks. This diversification spreads the risk over a number of stocks, thereby offering an investor a lower risk of a catastrophic loss in the value of his or her investment portfolio. In general, an investor purchases shares in a mutual fund, and can redeem those shares in accordance with the mutual fund's redemption policy, which most often determines the share price at the end of a trading day. Large redemptions by investors over a short time period force the mutual fund manager to sell shares in the underlying stocks. In the case of closed mutual funds, however, investors typically buy and sell the shares amongst themselves in a securities market.
The composition of a mutual fund can be based on a number of criteria. While some mutual funds reflect the composition of particular well-known indexes, such as the 30 companies comprising the Dow Jones' Industrial Averages or the Standard & Poor's 500 (S&P 500), others are specific to a geographical area (e.g., an “Asia” fund), an industry sector (e.g., “biotechnology”), investment objective type (e.g., “growth”), or have some other characteristic in common. Most mutual fund, regardless of their composition, include stocks traded on more than one exchange.
Indices, index funds and mutual funds comprise a basket of shares from different stocks whose contribution in any given index or fund is weighted. In this context, a ‘weight’ or ‘weighting’ refers to the proportion of a component securities' value to the whole, and this can be done in a number of ways. For example, the Dow Jones 30 industrials are “price” weighted and so the Dow Jones average is based on the price of one unit of each component member, divided by a divisor. The S&P 500, on the other hand, is “market cap” weighted and so each member component is represented according to its market capitalization. While “price” and “market cap” weighting are the most commonly used weights, other weightings based on measures of the volatility of the component members or other arbitrarily created criteria, may also be employed.
The manager of an index fund which tries to mimic the market cap weighting of the S&P 500, tries to keep the weighting of the stocks in the index fund to reflect that of the S&P 500. This is typically done by adjusting the number of shares of many, if not all, of the different stocks, perhaps as often as on a day-to-day basis, depending on the fluctuation of the share prices of each. To do this, the fund manager places orders to buy or sell each of the stocks that he wishes to trade. In the case of the stocks listed on the NYSE, the orders are handled by the specialists and each trade is handled automatically and efficiently. However, in the case of stocks listed on the NASDAQ, due to the dealer structure, there may be delays and inefficiencies in executing each of the various trades. For example, if the S&P 500 has 446 stocks from the NYSE and 54 stocks from the NASDAQ, the orders for the 446 stocks may be handled automatically by the corresponding specialists, while the orders for the remaining 54 stocks are handled by various dealers and so the resulting trades may encounter delays and inefficiencies, which may cost the fund dearly, when the stock market is volatile.
Standard & Poor's Depository Receipts (SPDRs, conventionally pronounced ‘spiders’) are derivative equities traded on the AMEX via specialists. SPDRs allow one to buy or sell an entire portfolio of the underlying stocks in a single transaction. The SPDRs are equity instruments devised to package equity into a single listed security. They represent ownership in a SPDR Trust, a unit investment trust which holds a portfolio of common stocks that tracks the price performance and dividend yield of the S&P 500 Index. A SPDR is like an open end unit trust that is rebalanced daily to the S&P 500 Index and may trade at a premium or discount to the S&P 500 futures. SPDRs may be held like a stock for a long time and entitle the holder to quarterly cash distributions corresponding to the dividends that accrue to the S&P stocks in the underlying portfolio, less expenses. Thus, an SPDR is effectively a share in a trust whose sole purpose is to invest in the selected underlying stocks, the share being traded on the AMEX. Sector SPDRs which focus on categories of stocks have been formed, and these include such categories as Basic Industries, Consumer Services, Consumer Staples, Cyclical/Transportation, Energy, Finance, Industrial, Technology and Utilities. In addition, mid-cap SPDRs which mirror the composition of the S&P-400 Midcap funds have also been formed. Unlike traditional index mutual funds that are purchased and redeemed only at end-of-day closing prices, SPDRs trade at real-time prices throughout the trading day. Therefore, an SPDR representing the S&P 500 allows one to get in and out of the S&P 500 whenever one wants, both easily and conveniently. Furthermore, since SPDRs are traded just like stocks, they provide quarterly dividends, can be bought on margin, sold short, and so forth, and options in the SPDRs can also be traded.
In a volatile trading day, share prices of a particular stock may change drastically and a large number of buy and sell orders may hit the floor. On the NYSE or the AMEX, the volume of such orders does not pose a major problem since a single specialist handled the trades. However, handling such orders on the NASDAQ is somewhat more problematic, because of the large number of dealers who can potentially handle transactions in a particular stock. To offset the risks associated with volatility in the share price of a particular stock, a specialist in that stock may trade in the stock for the benefit of his or her firms' own portfolio. In the case of an SPDR, the SPDR specialist can buy and sell the underlying basket of equities comprising that SPDR. In the case of an SPDR which is based on the S&P 500 or other index which includes stocks found both on the NYSE and the NASDAQ, the SDR specialist must quickly buy and sell shares in both markets. For reasons stated above, while the trades on the NYSE are done quickly and efficiently through automatic execution orders done though specialists, the trades on the NASDAQ may not take place so fast, due to the multiple dealers involved.